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Under-your-control investing

February 12, 2018 | Robin Bowerman, Vanguard Investments Australia

The long-term outlook for a more challenging investment market with low-interest, subdued equity returns and higher volatility has led to some investors wondering whether a radically new investment strategy is warranted.

However, Vanguard's latest economic and investment outlook for 2018 and beyond suggests that disciplined, diversified and patient investors who concentrate on factors within their control are likely to be rewarded over the long term.

The report emphasises its view that the answer to the prevailing challenges for investors is not adopting a "shiny new" approach to investing or "aggressive tactical shifts" to a portfolio.

Under-your-control factors include, of course, adhering to the fundamentals of sound investment practice such as creating an appropriately-diversified portfolio, setting goals and having realistic expectations for returns.

And the report confirms that such under-your-control factors as working longer before retiring, spending less and minimising investment costs can have a big impact on the likelihood of investment success.

An investor's concentration on factors within their control far outweighed making short-term tilts to a portfolio in an effort to boost returns.

Interestingly, the action of saving more can have one of the biggest impacts on the likelihood of investment success. Like many aspects of good investment practices, simple strategies are often among the best.

Investors should concentrate on what they can control - not on what they can't control.

You have no control, for instance, on the emotions of other investors but you can keep your own emotions in check when making investment decisions.

Closing your insurance gap

February 12, 2018 | Robin Bowerman, Vanguard Investments Australia

A fundamental personal finance trap is to assume that your super fund's default insurance cover is adequate for your circumstances. Chances are it isn't.

The latest Underinsurance Australia report, recently released by independent consultants and actuaries Rice Warner, makes the point that most super funds aim to provide for part of their members' insurance needs through their default cover.

"The median default cover of superannuation funds meets roughly 50 per cent of basic-level life cover needs for average households," the report comments, "but a much lower proportion for families with families."

As the report emphasises, striking a balance between adequacy and affordability is always a challenge for super funds given that member demographics and family circumstances can significantly vary.

The levels of default life cover for some younger members was likely to be higher than their needs given that many were not married and had no children. "In contrast, with changing family formation patterns and increasing debt levels at higher ages, default covers are often inadequate for older members."

Key conclusions include:- The median level of life cover meets only 47 per cent of basic needs.- The median level of life cover meets just 28 per cent of the amount needed to ensure that family members and dependants can maintain their standard of living after the death of a parent or partner.- The median level of TPD cover meets only 14 per cent of needs.- The median income-protection cover meets 21 per cent of needs.- Only a third of the working age population (excluding dependent children) have income-protection cover.

Most Australians gain any of their life, disability and income-protection insurance through their large super funds. This means that a useful starting point for measuring your insurance needs is to understand the level of default cover provided by your fund.

Inadequate insurance cover can rapidly disrupt a family's personal finances and investment planning following the death or loss of a job of a parent or partner.

It's worth repeating that chances are that your super fund's default cover is inadequate for your needs. Much depends on family circumstances.

Ensuring that your family's insurance cover is adequate ranks highly among the principles of sound personal financial and investment planning.

Rising risks to the status quo

January 28, 2018 | Robin Bowerman, Vanguard Investments Australia

The financial markets' low volatility underscores investors' conviction that the long-term global economic trends of modest growth and tepid inflation will also define shorter-term cycles. But risks lie in mistaking the trend for the cycle.

The most pronounced risk in our 2018 outlook is that already tight global labor markets will grow tighter, finally leading to a cyclical uptick in inflation. A wage or inflation spike in 2018 could lead markets to anticipate a more aggressive normalization from historically low interest rates just as central banks are either normalizing monetary policy or contemplating doing so, thereby producing a market-rattling shock.

Global investment outlook: Higher risks, lower returnsFor 2018 and beyond, our investment outlook is modest, at best. Elevated valuations, low volatility, and secularly low interest rates are unlikely to be allies for robust financial market returns over the next five years. Downside risks are more elevated in the equity market than in the bond market.

In our view, the solution to this challenge is not shiny new objects or aggressive tactical shifts. Rather, our market outlook underscores the need for investors to remain disciplined and globally diversified, armed with reasonable return expectations and low-cost strategies.

What follows is a brief overview of our economic and investment outlook for 2018.

Economic growth: Unemployment, not growth, is the keyWe expect economic growth in developed markets to remain moderate in 2018, while strong emerging-market growth should soften a bit. Yet investors should pay more attention to low unemployment rates than GDP growth at this stage of the cycle for prospects of either higher spending for capital expenditures or wage pressures. We see low unemployment rates across many economies declining further. Improving fundamentals in the United States and Europe should help offset weakness in the United Kingdom and Japan. China's ongoing efforts to rebalance from a capital-intensive exporter to a more consumer-based economy remains a risk, as does the need for structural business-model adjustments across emerging-market economies. We do not anticipate a Chinese "hard landing" in 2018, but the Chinese economy should decelerate.

Inflation: Secularly low, but cyclically risingPrevious Vanguard outlooks have rightly anticipated that the secular forces of globalization and technological disruption would make achieving 2% inflation in the United States, Europe, Japan, and elsewhere more difficult. Our trend view holds, but the cycle may differ.

In 2018, the growing impact of cyclical factors such as tightening labor markets, stable and broader global growth, and a potential nadir in commodity prices is likely to push global inflation higher from cyclical lows. The relationship between lower unemployment rates and higher wages, pronounced dead by some, should begin to re-emerge in 2018, beginning in the United States.

Monetary policy: The end of an eraThe risk in 2018 is that a higher-than-expected bounce in wages—at a point when 80% of major economies (weighted by output) are at full employment—may lead markets to price in a more aggressive path or pace of global monetary policy normalization. The most likely candidate is in the United States, where the Federal Reserve is expecting to raise rates to 2% by the end of 2018, a more rapid pace than anticipated by the bond market. The European Central Bank is probably two years away from raising rates or tapering bond purchases, although a cyclical bounce may lead to a market surprise. Overall, the chance of unexpected shocks to the economy during this tightening phase is high, as is the chance that balance-sheet shrinkage will have an unpredictable impact on asset prices.

Investment outlook: A lower orbitThe sky is not falling, but our market outlook has dimmed. Since the depths of the 2008–2009 global financial crisis, Vanguard's long-term outlook for the global stock and bond markets has gradually become more cautious—evolving from bullish in 2010 to formative in 2012 to guarded in 2017—as market returns have risen with (and even exceeded) improving fundamentals. Although we are hard-pressed to find compelling evidence of financial bubbles, risk premiums for many asset classes appear slim. The market's efficient frontier of expected returns for a unit of portfolio risk now hovers in a lower orbit.

Based on our "fair-value" stock valuation metrics, the medium-run outlook for global equities has deteriorated a bit and is now centered in the 4 %–6% range. Expected returns for the U.S. stock market are lower than those for international markets, underscoring the benefits of global equity strategies in the face of lower expected returns.

And despite the risk for a short-term acceleration in the pace of monetary policy normalization, the risk of a material rise in long-term interest rates remains modest. For example, our fair-value estimate for the benchmark 10-year U.S. Treasury yield remains centered near 2.5% in 2018. Overall, the risk of a correction for equities and other high-beta assets is projected to be considerably higher than for high-quality fixed income portfolios; balanced portfolios are expected to stunt a rise in return volatility.

New Year resolutions, New Year strategies

January 28, 2018 | Robin Bowerman, Vanguard Investments Australia

Stop procrastinating. These two words can provide an excellent starting point for investors who are determined to set meaningful resolutions and strategies for 2018 and beyond.

Behavioural economists have long warned that the common traits of procrastination and inertia can be highly detrimental to investors.

Most of us would recognise the long-term rewards of setting realistic investment goals, creating an appropriately-diversified portfolio and saving more for retirement. Yet even with the best intentions, we may never quite get around to it.

In short, we procrastinate and waste opportunities to improve our chances of investment success.

Each of the following points should help investors break through their investment and personal finance inertia:

- Increase your regular super contributions from the beginning of the New Year: This is a straightforward way to tackle your inertia and procrastination. Are you making the highest salary-sacrificed and tax-deductible contributions that you can afford? For 2017-18, the concessional contributions cap for all eligible members is $25,000.

- Cut your investment costs: One of the simplest ways to increase your chances of investment success is to cut your investment costs. As the majority of higher-cost actively-managed funds have struggled to beat their benchmarks, low-cost traditional index funds and index-tracking exchange traded funds (ETFs) are surging in popularity. (Recent ASX research shows that the market capitalisation of Australian-listed exchange traded products, most being index ETFs, reached $35.25 billion by the end of November – up from less than a billion dollars a decade ago.)

- Consider adopting a total-return approach: This approach should help prevent retirees in particular from falling into the trap of abandoning carefully-diversified portfolios in an effort to boost a portfolio's income in this more challenging low-interest, lower-return environment. (See Vanguard's latest economic and investment outlook.) A total-return approach focuses on both the income and capital growth generated by a portfolio. This approach should help maintain a portfolio's diversification, allow more control over the size and timing of portfolio withdrawals and increase a portfolio's longevity.

- Tick-off investment fundamentals: Early in 2018, check whether you have the fundamentals of sound financial planning/investing practices covered. These include: Set clear and achievable goals, create an appropriately-diversified portfolio and, once again, minimise investment costs.

- Build-up your mortgage buffer: Homebuyers who make higher repayments than the minimum required develop buffers to help cope with future rate rises and unexpected financial setbacks. The Reserve Bank's holding of the official cash rate at a record low of 1.5 per cent highlights this sustained opportunity to build your mortgage buffer.

- Aim to eliminate your debt before retirement: Ideally, we should enter retirement with our mortgages paid off and without any other debit. This should leave us open to spend our retirement income on financing our lifestyle. Unfortunately, various research shows "grey debt" is rising at a time when waves of baby boomers are retiring.

- Keep your credit card under control: Disciplined consumers pay off their total credit card bill each month to avoid any interest and minimise the credit limit on their cards to reduce the temptation to overspend. The Australian Bureau of Statistics reports that the average pre-Christmas credit card limit was more than $9000; that's a hefty amount of repay at high interest rates for those who "max out" on their cards.

Finally, make sure your resolutions/strategies for 2018 and beyond are achievable given your circumstances. By setting the bar unrealistically high, you will face almost certain disappointment.

Have a prosperous New Year.

An investment 'starting point'

January 10, 2018 | Robin Bowerman, Vanguard Investments Australia

A recent Vanguard research paper describes index investing – through conventional index funds or exchange traded funds (ETFs) tracking chosen indices – as a "valuable starting point for all investors".

By using indexing as their starting point, many investors then decide to index their entire diversified portfolios. This is understandable given that research repeatedly shows that the median active manager underperforms after costs and that future outperformers are difficult to identify.

And many investors decide to keep indexing as the core of their portfolios while introducing satellites of actively-managed funds in an effort to outperform the market.

This research paper, Making the implicit explicit: A framework for the active-passive decision, emphasises that investors face a series of challenges when placing some of their portfolio in actively-managed funds rather than taking an all-indexing approach.

These challenges include identifying talented active managers, the typically higher cost of active management and the investors themselves having the patience to cope with inevitable periods of underperformance.

In turn, the paper reiterates that the greater an investor's ability to address these challenges (perhaps with professional advice), the "greater the suggested allocation to active funds".

Investors considering both active and passive investments would benefit from explicitly addressing these issues or challenges, providing a clear and informed process for making an active-passive decision.

As discussed in the research, here are a few things for investors to keep in mind:- An investor's expectation for an active manager to outperform its benchmark is a critical judgment of that manager's talent.- The odds of active manager outperformance rise as costs reduce.- Even the most successful managers over the long term will typically experience long periods of underperformance. Investors should consider their willingness to remain patient at such times.- Active management brings additional risk in the pursuit of outperformance. Investors should evaluate their tolerance to this added risk.

Given that so much depends on an investor's personal circumstances including performance expectations and risk tolerance, there is no one-size-fits-all approach to making a decision on the passive-active investment split.

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